In general, liquidity and confidence drives markets. Many point to
leverage, low interest rates and high government spending as the source of
America’s market boom and recent uptick. It is clear to me that the surge in
Chinese markets this year is speculation largely due to the huge jump in bank
lending and the lack of many viable investment options to put this money to
work.
The Chinese refer to putting this cash into markets as “stir frying”.
The MSCI Emerging Markets index, for
example, trades at a price-to-earnings ratio of 16.1, which is 25 percent
higher than its average P/E over the last five years. The Shanghai
Composite in China recently hit a one-year high while the Hang Seng index in
Hong Kong reached a level unseen since last October.
China’s hot market has overtaken Japan to become the world’s second
biggest stock market by capitalization as investors pile into the fast-growing
economy. China’s listed companies had a market capitalization of $3,210bn as of
July 15 compared with Japan’s $3,200bn, according to Bloomberg data.
Investors have driven the Shanghai and Shenzhen markets up 75 percent
and 95 percent respectively this year, thanks to the government’s $600bn
stimulus plan, the effect of which was reflected in the hard to believe
reported 8% percent second-quarter economic growth. The two Chinese stock
markets are among the best performers globally this year though others in the
region no doubt buoyed by Chinese growth such as Taiwan and Indonesia are not
far behind.
The economic rebound has been driven by a powerful source of liquidity
controlled by the ruling Communist party: a jump in lending by state-owned or
controlled banks. Chinese banks, all but a handful of which are owned by the
government, lent over a trillion dollars in the first half of this year, nearly
double the total loans extended in the whole of 2008. As for June’s
lending, at $220bn in new loans confirmed the trend as banks opened the spigots
under the watchful eyes of the mandarins, just as they did in March (to
$280bn).
This liquidity is fueling the Shanghai Stock Exchange, where daily volumes
are currently three times the five-year average.
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Some state-owned companies have set up
separate divisions just to speculate and trade stocks. We have seen this cycle
before. Keep in mind that the Shanghai composite was as low as 1,717 last
November — a 70 percent drop from its peak in late 2007.
In the first half of the year, it is
estimated that banks operating in China made about $1 trillion in new loans —
an astounding figure considering that all of the 2008 bank loans totaled about
$620 billion.
What about earnings? The 741 companies in the MSCI Emerging Markets
index that reported results since the end of the first quarter posted an
average earnings drop of 92 percent, trailing analysts’ estimates by 14
percent, according to Bloomberg data. That compares with a 46 percent profit
slide for Europe and a 31 percent fall for the S&P 500, Bloomberg data
show.
What about valuations?
Are investors paying too much for growth? The MSCI emerging markets
index trades at 15.6 times reported earnings, compared with just over 14 for
the S&P 500, according to weekly data compiled by Bloomberg. When
developing nations last commanded a premium, the 22-country benchmark sank 54
percent in the next year.
But there are some that feel that this premium is now justified with
banks in Asia generally healthy compared to developed countries and the growth
potential of emerging markets going forward. Using a peg ratio whereby a
market’s price earnings ratio is divided by its growth rate, many emerging
markets still look attractive.
Another opportunity may be investing in China’s H shares that trade in
Hong Kong. Some estimate that they trade at about a 40% discount to the A
shares for the same companies trading in Shanghai and Shenzhen. iShares
FTSE/Xinhua China 25 Index (FXI) is a basket of 25 of these companies.
It’s hard to fight this kind of momentum
but investors need to stay on top of these markets and manage the risk. Be wary
of getting carried away with China’s and emerging market bull markets. The MSCI emerging-market index had 13
bull-market rallies of at least 20 percent and 12 bear-market declines of the
same magnitude according to data compiled by Birinyi Associates. That compares
with five bull markets and four bear markets for the S&P 500 during the
same period.
Enjoy the sizzle but watch out for the burn. The sting may be in the
tail. I am keeping my hand on the leverage inverse ETF to FXI (FXP).
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